Make Your Kid Rich With a Roth IRA

Here’s a tax strategy that will, in one swoop, take money away from the IRS and help your kids make their way in the world. It’s powerful and at the moment vastly underutilized.

Set up a Roth retirement account for a youngster. The money grows, undisturbed by taxes, for 50 years. The kid spends it when he’s 69.

I know the technique is underutilized because I have encountered more than one financial institution befuddled by the idea that minors can have IRAs.

A youngster can put up to $5,000 a year in a tax-sheltered retirement account, but can fund it only with dollars earned working. You can help out with the dollars, but the child has to work in a real job.

“Ever heard of supply side economics?” you ask the kid. “Here’s an incentive. If you earn a dollar, I’ll give you another dollar. Your tax rate, not counting payroll taxes, will be a negative 100%. But you have to put the money I’m giving you away until you’re retired.”

If your daughter earns $4,000 as a lifeguard, you let her spend that money as she normally would (on college, if she’s expected to chip in, or if not then on whatever). You come up with the $4,000 to put in the retirement account.

With a Roth IRA the worker gets no deduction as the money goes in, but enjoys a full tax exemption on money coming out.

For a middle-aged worker the choice between a deductible IRA and a nondeductible Roth is a tough one to make. That’s because the deduction is worth a lot of money to someone in his peak earning years and therefore a high tax bracket. A 45-year-old worker has to weigh that benefit against the cost imposed at the other end: Every dollar coming out of a deductible IRA is taxable.

For a teenager working summers, the choice is not tough at all. For him, the up-front deduction is worthless. He’s probably in a 0% income tax bracket.

Here’s why. A student under 24 who can be claimed as a dependent on a parent’s return (and that would include a child you’re putting through college) gets a standard deduction equal to the sum of $300 and earned income. There’s a collar around this sum: The standard deduction can’t be less than $950 or more than $5,800. (The upper limit is up $100 from the 2010 figure.)

The effect of this formula is a little complicated for the child with investment income, but for one without investment income it works like this: The first $5,800 pulled down from a part-time job is free of income tax.

So the kid passes up the opportunity to deduct anything now and declares the account to be a Roth. At the retirement end the account, by then much, much bigger, will be scot-free.

Will your offspring honor the promise not to touch the money for 50 years? You won’t be around to make sure. For what it’s worth, the IRS will help out by threatening a penalty on the earnings if there are any withdrawals before age 59.

Assuming you can persuade your bank or mutual fund company to open the account at all (with you as guardian, if the child is under 18), you may have some minimum account hurdle to overcome. But note that you can combine two years of earnings in one deposit. An IRA contribution can be made either in the year in which the earned income comes in or by April 15 (in 2011, April 18) of the year following.

So, a deposit next March could combine this summer’s earnings with a conservative estimate of what the earner expects in 2012. IRA deposits can if necessary be undone, within certain time limits.

Vanguard’s low-cost index funds are a good place to put money away for 50 years. Most of them have $3,000 minimums but one, Vanguard Star, will let you start with $1,000.

Make your children into savers when they are young. If they don’t break the habit, they will have more prosperity and less angst than most Americans.

One caveat: Colleague Janet Novack reminds me that you should think about how this move will affect college financial aid. While parents' retirement accounts aren't considered available to pay for college, the kids' accounts generally are. In any event, an intergenerational gift almost never makes sense if it means starving the donor's own retirement account.

My philosophy is that it is hard, but not impossible, to beat the market, and that it is easy, and imperative, to save on taxes and money management costs. I graduated from Harvard in 1973 with a degree in linguistics and applied math. I have been a journalist for 40 years, ...